MCLR( Marginal Cost of Funds based Lending Rate )

The marginal cost of funds based lending rate (MCLR)
refers to the minimum interest rate of a bank below which it cannot lend,
except in some cases allowed by the RBI.

Reasons for introducing MCLR

RBI decided to shift from base rate to MCLR because
the rates based on marginal cost of funds are more sensitive to changes in the
policy rates. This is very essential for the effective implementation of
monetary policy. Prior to MCLR system, different banks were following different
methodology for calculation of base rate /minimum rate – that is either on the
basis of average cost of funds or marginal cost of funds or blended cost of
funds. Thus, MCLR aims

To improve the transmission of policy rates
into the lending rates of banks.

To bring transparency in the methodology
followed by banks for determining interest rates on advances.

To ensure availability of bank credit at
interest rates which are fair to borrowers as well as banks.

To enable banks to become more competitive
and enhance their long run value and contribution to economic growth.

How to
calculate MCLR?

The calculation of MCLR is linked to the tenor or the
amount of time that is left for the loan repayment. This tenor-linked benchmark
is internal in nature. The determination of the actual lending rates is done by
means of adding the elements spread to this tool. The banks then publish their
MCLR after reviewing it. This review and publication take place for varying
maturities, monthly or as per a pre-announced date. The four main elements of
MCLR are made up of the following:

Tenor Premium

There is uniformity in the tenor period for all sorts
of loans for the said residual tenor. This means that the tenor premium is not
specific to a loan class or a borrower.

Marginal Cost of Funds

This concept is quite new in the MCLR method and is made up of components like
the Return on Net Worth and the Marginal Cost of Borrowings. The weight of
the Marginal Cost of Borrowings is 92 percent while the weight of Return on Net
Worth in the Marginal Cost of Funds is 8 percent.

This 8% is equivalent to the risk of weighted assets as denoted by the Tier
I capital for banks. The Marginal Cost of Borrowing is the average rate using
which the deposits of maturities that are similar were raised during a
specified time period prior to the date of review. It is weighed in the bank’s
books by their outstanding balance.

Operating Cost

This is linked to providing the cost of raising the funds, barring the
costs recovered separately by means of service charges. It is, therefore,
connected to providing the loan product as such.

Negative carry on account of CRR

The need for negative carry on the CRR (Cash Reserve Ratio) takes place
because of the return on the CRR balance is zero. In the scenario when the
actual return is less than the cost of the funds, there arises the negative
carry on mandatory Statutory Liquidity Ratio Balance.

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